The AAF Virtual Debates: Charles Calomiris on State-Owned Banks

Editor's Note: The following post was submitted by Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at Columbia University, as part of the AAF Virtual Debates. In this opening statement, Professor Calomiris gives a negative answer to the question: "Can state-owned banks play an important role in promoting financial stability and access?"

It is quite correct to say, as Asli’s introduction to this debate noted, that academic work strongly supports “a growing consensus that the track record of state-owned banks has been quite poor” and has been associated with “inefficiencies, increased risk of crises, and less inclusion and greater concentration of credit,” and support for “cronies.” Not only do studies of the performance of state-controlled banks confirm these findings over and over again, the presence of state-controlled banks is so clearly understood to be a poisonous influence on financial systems that measures of the presence of state banking are often used as control variables when evaluating the performance of private banks. These studies indicate powerfully the negative effects of state-controlled banks on the banking systems of the countries in which they operate. The winding down of state-controlled banks was rightly celebrated in many countries in the 1990s as creating new potential for economic growth and political reform.

Why are state banks such a disaster? There are three main reasons:

First, government officials do not face incentives that are conducive to operating well-functioning banks. As my colleague Professor Rick Mishkin likes to say, banks are the “brain of the economy”—the institutions charged with the role of allocating capital wisely to those able to make best use of this scarce resource. Government officials tend to focus on other objectives, and they face incentives that reward politically motivated, rather than economically motivated, allocations of credit. Additionally, they tend not to be trained in credit analysis as well as private bankers, and they are typically not incentivized by governments to maximize economic effectiveness (since that is not what the political masters of the bank want it to do).

Second, the politically motivated allocation of funds to crony capitalists has adverse consequences for the political and social system of a region or country. State-controlled banks are a breeding ground for corruption of elected and appointed government officials, the financial regulatory authorities, and the courts. Not only do they stunt the growth of the economy, they also weaken the core political and bureaucratic institutions on which democracy and adherence to the rule of law depend.

Third, state-controlled banks are, in the words of Professor Gerard Caprio, “loss-making machines.” Because they are not geared toward profitability or the aggressive enforcement of loan repayment, but rather toward rewarding political cronies with funding, the losses of state-controlled banks pose a major fiscal cost for governments. Those fiscal costs crowd out desirable government initiatives, and given the large size of the losses, can be a threat to the solvency of government and a source of inflationary deficit financing.

It is remarkable to me that the recent economic crisis has spurred a renewed interest in state-controlled banks. From my perspective, the crisis has only reconfirmed the extreme damage that politically motivated lending can inflict. The quasi-state-controlled U.S. entities Fannie Mae and Freddie Mac accounted for more than half of the funding of subprime and Alt-A mortgages leading up to the crisis. There is clear evidence demonstrating that political motivations drove the intentional risk taking and deterioration of underwriting standards at those institutions after 2003—a crucial ingredient in the subprime boom of 2004-2007. Government quotas dramatically increased the funding that Fannie and Freddie had to supply to low-income and underserved borrowers, but the supply of creditworthy low-income and underserved borrowers was limited. As an inevitable consequence, lending standards were relaxed. Emails between risk managers and senior management show that managers entered into undocumented mortgage lending in 2004 primarily out of a desire to meet politically driven mandates.

The U.S. experience is not unique. Political motivations drove Spanish cajas to support a real-estate boom that ended in a massive bust. In Germany, state-controlled banks also made horrible investment decisions, in this case perhaps reflecting incompetence more than corruption or political motives for channelling funds. Looking back historically at other cases of extreme booms and busts, or at the modern literature on state-controlled banking, it is clear that state-controlled lending has been a major contributor to unwise and politically motivated risk taking that has ended badly over and over again.

Why, then, is the crisis reviving interest in state-owned banks? The huge crisis-related losses of equity capital in the banking system and the subsequent stepping up of regulatory oversight over banks have resulted in a short-term contraction in the supply of credit. This credit crunch magnified the decline of GDP during the recession, and slowed the pace of the recovery. As my own research on the effects of credit contraction during the Great Depression shows, it can take several years for the effects of such a credit crunch to dissipate.

In such an environment, it may seem appealing to pass a law creating a state-owned bank with the goal of re-starting the rapid flow of loanable funds. But such an initiative would be short-sighted in the extreme. Rather than promoting sustainable growth, it would slow growth over the medium or long run, as funds would be channelled to low-productivity users. A move to support state-controlled banks would not only lead to waste and slow growth, it would raise systemic risk (as Fannie and Freddie, and the Spanish cajas so clearly show), promote corruption of our government officials and institutions, and lead to fiscal losses that could threaten the solvency of government and lead to high inflation.

Comments

As Mr. Calomiris argues, the evidence is overwhelmingly stacked against state-banks. They have lower profitability, higher NPLs, are less efficient, and have larger government securities portfolios. They have also been used as political instruments and their presence is associated with crises.
However, a priori state banks can still have beneficial effects. Theoretically speaking, they can help kick-start (basic) markets, address enforcement problems and other market failures, increase access, behave counter-cyclically, etc. There are certainly success stories such as Chile's BancoEstado and the South Africa Development Bank (Heinz Rudolph (2010)).
And as Mr. Franklin pointed out, evidence also suggests state banks have expanded during the crisis which has surely helped credit-starved but otherwise productive companies in both developed and developing countries.
Additionally, state banks can also fulfill key government finance and employment mandates (although this is not necessarily desirable in the long run) and help mobilize savings in early stages of financial development because the public perceives them as being backed by the state. This can also be stabilizing during a crisis.
There are also a few technical/empirical points that could be relevant to the performance debate:
* My reading of the empirical evidence is that the poor performance is mostly driven by developing countries in the sample. I thought the case against state banks is empirically less clear in developed countries (although the effects of politically motivated lending in developed countries are now pretty clear...). This finding suggests governance and institutional issues play a large role.
*Additionally, I believe it is Levy-Yeyati, Micco, and Panizza (2007) that revists the seminal La Porta, Lopez-de-Silanes and Shleifer (2000) paper with more data and an instrumental variables approach. If I recall correctly, they find that state ownership is no longer significantly associated with financial development and/or economic growth.
*Another important point in this discussion is that although state-banks have broader mandates than commercial banks, they are held to the same performance standard in many parts of the literature (i.e. analysis of ROE, ROA, etc.). However, this evaluation approach omits any beneficial effects state banks might have as regards their development mandates putting state banks at a potential disadvantage. In fact, one could even argue that state banks should have lower profitability, etc. if they are carrying out their development mandates correctly.
So taken together, I think government ownership is not inherently bad, since there are success stories. Rather, the evidence suggests that poor mandates, subpar supervision, opaque governance, weak institutions, etc. are driving factors behind the sobering performance of many state banks.
In other words, there is a cost-benefit trade off. Some got it right, but many didn't.

I tend to agree with Erik's middle ground thinking on the question of whether it is good to have state-owned banks. I think they have been primarily successful in countries that have good institutions and also in situations where their main role is not to substitute private banks but rather to help bridge gaps in the provision of financial services (like the case of Nafin in Mexico). My sense is that cases like banco de Estado are outliers. In general, research that Asli, Thorsten and I have done on the factors correlated with financial outreach indicates that there is no significant association between greater government ownership of banks and financial access across countries.

Just would argue that the Swedish banking sector was subject to a great no of regulatory controls between the end of WW2 and early 1980s, basically the "golden age" of the country's growth and development. And there were no banking or financial crisis! As commentators have been mentioning I believe the story is much more complicated than concluding that state controlled banks are bad. Even today the governments of Finland, Norway and Sweden owns the majority of Nordea, one of the largest bank conglomerates in the region I believe, and it is doing quite well.

If you forget for a minute Mr Calomiris high dose of ideological arguments, it is not easy to find real arguments in his note. I do not find convincing the argument that state financial institutions (SFI) are bad because their past performance has been poor, and because their officials are not trained in credit analysis. This is not only simplistic, but also absurd. We all know about the disastrous experience of many countries with SFIs, but little has been said about the successful experience of few SFIs in some others. It is interesting to understand what has gone right in these SFIs, and why these SFIs have added some value to the financial development of these countries.
In the past few years, the performance of privately owned banks has not been an example around the world, and it is understandable that policymakers in the future do not want to leave the huge fluctuations in credit allocation to privately owned banks, which only conduct their business based on short term return maximization. Since they may operate on a longer term horizon, SFIs may play an important role in smoothing the credit cycle and avoiding abrupt disruptions in credit allocation due to short-term decisions of privately owned commercial banks. SFIs are not the panacea either, but under certain conditions, they can be welfare improving.
In order to operate properly SFIs need to have a proper mandate, a proper structure of governance, adequate systems of risk management, properly designed performance measures, and need to be supervised as commercial banks. Few SFIs around the world operate under these conditions, but these countries have been successful in weathering the crisis compared to the ones that did not have these tools.
The World Bank add little value to our client countries simply by saying that SFIs are evil, as counties are logically moving in that direction. We would add much more valuable input by explaining the risks of having SFIs and how to mitigate them.

I disagree with Mr. Heinz' statement. This is not a question of ideology. Evidence is huge refering to the poor efficiency and weak benefits of state-owned banks. A deep reason is the lack of incentives, there are no owners: who would believe that congressmen represents perfectly the average citizen? and they will be careful allocating or controlling to those who should allocate the state-owned bank funds?, so who will administer the taxpayers funds? or who would allow the bank to go into bankruptcy if it makes losses?. Unfortunately this experience is even more pervasive in less developed countries (most of the world map).

Since the late 80s, I have been hearing the arguments presented by Prof Calomiris against state-owned banks. But since then a lot of things have changed. As documented by C. Trivelli, ALIDE and others, in various countries there is a growing trend to move state-owned banks aways from first tier operations into second-tier operations, to narrow their mandates, to apply the same regulation that is applicable to commercial banks, and to develop better systems to monitor and evaluate their performance. Moroeover, during the past financial crisis, some state-owned banks played a positive role in alleviating liquidity and credit constraints. Perhaps all these recent developments should challenge the way we look at state-owned banks.
Prof. Calomiris refers to state-owned banks as if they were an homogenous group of financial institutions. Reality, however, is much more complex. Across countries and within countries, the group of state-owned banks shows enormous differences in terms of their mandates, performance, corporate governance arrangements, business models, funding structures, and the way they are regulated and supervised.
Some institutions -- like the World Bank itself (yes, we are also owned by states), Korea Development Bank, FIRA, and many others that participants in this blog have mentioned -- have a strong performance record. The problems highlighted by Prof. Calomiris would hardly apply to this group of state-owned financial institutions.
In my view, it would be useful to move the debate away from ideological considerations into more pragmatic discussions. What are the specific factors, or combination of factors, that have allowed some state-owned banks to perform well and maintain their soundness and profitability over the years? Is it really impossible for low-income countries to have a well administered state-owned bank? Who are the champions and what can we learn from them?

Yes, state owned banks play important role in promoting financial stability and prosperity of economy only when it is a mixed mixture of Public as well as Private Banks. No doubt Public Banks are inefficient and politically influenced but private banks are concerned with their profit margins and only concentrate on profit making businesses to lend. There will always be a fear of high inflationary pressure on economy as private banks prefer more financing to high consumption, better margin goods manufacturers. In my view there should be a mixture of Public as well as Private Banks for any economy to prosper. Especially in India now, as we entered in a competitive arena Public Banks are also in competition with Private Banks in case of efficiency and better services. Rest all has been explained by our professors and you.

In his comment, Erik Feyen picks up on an important point: “state-owned” banks tend to have broader stated objectives than maximizing a measure of profit. Much of the evidence alluded to by Charles Calomiris is based either on profitability or on closely related measures. I have also written a paper a few years ago using this kind of comparison between the Landesbanken (owned by German states) and private banks, showing that the Landesbanken were a rather bad deal for the taxpayers. That seemed a fair comparison given that, Landesbanken have been essentially doing the same that a privately-owned wholesale bank would do. But such comparisons are trickier for other “non-private” banks such as (to stay with the German example) Sparkassen, i.e. savings banks. These also have relatively lower profitability (and related measures), but have historically performed functions that private banks did not.
Comparing the “performance” of state-owned and privately-owned banks requires taking account their different objectives. Doing it properly is not trivial.